AD Derivatives Podcast Featuring Neoman007, OTC Trader Ex-GSR

Welcome to the AD Derivatives podcast led by Director of Derivatives; Greg Magadini.

Featuring: Neoman007, Ex-GSR OTC Trader & Exotic Derivatives Specialist!

Ex-GSR OTC trader and exotic derivatives specialist, Neoman007 explores discussions about his career, crypto volatility, and pricing insights for trading exotic derivatives.

To get more market insights, follow Neoman's Telegram channel: https://t.me/itscorrekt

Background and Introduction to Volatility Trading

Neo's journey into volatility trading began in the traditional finance sector, where he worked as a risk quant in Singapore, focusing on model validation across various asset classes. He later transitioned into equity derivatives trading, initially joining as a desk quant before moving up the ranks to actively trade equity derivatives. His trading primarily involved baskets of autocallables on stocks and indices, managing significant notional and hedging exposures. The onset of COVID-19 marked a pivotal moment in his career, prompting him to leave the traditional banking sector and join GSR, a leading crypto market maker, where he continued to explore the world of volatility trading, now in the context of cryptocurrency.

The Impact of COVID-19 on Volatility Trading

COVID-19 was a defining event in Neo's career, particularly in how it impacted the trading of exotic derivatives such as autocallables. During the pandemic, volatility spiked, correlations converged to one, and there was a significant shift in dividend projections, particularly in equities. Prior to the pandemic, dividend projections were expected to grow at 3-5% annually for most stocks, but COVID-19 reduced these projections to nearly zero. This had a profound impact on the valuation of equity exotics, as dividends are a critical pricing parameter for these products.

One of the most significant challenges during this period was the underestimation of hedging costs by the local volatility models used by many banks. These models failed to account for the extreme skew in volatility surfaces during times of market stress, leading to the underpricing of hedging costs. As a result, when the market experienced significant drawdowns, the actual hedging costs far exceeded the estimates, leading to substantial losses for the trading desks.

Understanding Autocallables and Their Risk Structures

Autocallables are structured products where investors receive contingent coupons in exchange for selling an exotic put option on a basket of underlying assets. These products are complex, involving features such as barriers, knock-ins, and knockouts, with pricing heavily dependent on parameters like dividend projections and volatility surfaces. During normal market conditions, these products can be managed effectively. However, during extreme market events like COVID-19, the assumptions underlying their pricing models break down, leading to significant challenges in managing the associated risks.

Neo explained that the primary risk during such events comes from the desk being long volatility on exotic structures while shorting vanilla options in the market. During market crashes, the short vanilla positions, typically in the form of tail options on major stocks, quickly become at-the-money, leading to a scenario where the desk is effectively short volatility during a volatility spike. This misalignment between the long exotic and short vanilla positions results in significant P&L deterioration, particularly during extreme market events.

Transition to Cryptocurrency Markets

The extreme volatility and unique challenges faced during COVID-19 led Neo to transition into the cryptocurrency market, where he joined GSR. This move was driven by a long-standing interest in crypto and the desire to explore a new and rapidly evolving market. Despite initially viewing crypto as primarily a tech-driven sector, Neo quickly recognized the distinct market dynamics at play in the crypto space, particularly in the context of derivatives.

The Role of Perpetuals in Crypto Derivatives

One of the most notable innovations in the crypto derivatives market is the concept of perpetual contracts, or "perps." Unlike traditional derivatives, perpetual contracts have no expiration date and are primarily maintained through funding rates that keep their prices in line with the underlying spot markets. However, Neo highlighted that the perpetual market in crypto operates differently from traditional futures markets. In crypto, the liquidity in the perpetual market often exceeds that of the spot market, indicating that perpetuals can trade independently of the underlying assets.

This independence is particularly evident in scenarios where new tokens are launched with perpetual contracts before the spot market for the token exists. Market makers are willing to provide liquidity in these pre-launch perpetuals despite the absence of a spot market to hedge against. This phenomenon underscores the unique nature of the crypto derivatives market, where liquidity begets liquidity, and market making is driven more by confidence in perpetual market dynamics than by traditional arbitrage relationships with spot markets.

Challenges and Opportunities in Hedging Crypto Derivatives

Hedging strategies in the crypto derivatives market differ significantly from traditional finance, primarily due to the nature of perpetual contracts. In traditional markets, hedging involves maintaining a balance between long and short positions across different instruments. However, in the crypto market, particularly with perpetuals, the relationship between spot and derivatives markets is less straightforward. This complexity requires market participants to adopt more nuanced strategies to manage risk effectively.

Neo emphasized that while tail risk protection strategies, such as buying deep out-of-the-money options, can be theoretically appealing, they are often impractical in the highly volatile and fast-moving crypto market. The timing and execution of these strategies are critical, and misjudgments can lead to significant losses. Therefore, while hedging remains an essential aspect of managing risk in crypto derivatives, it requires a deep understanding of the unique market structure and dynamics.

Exotic Options in Crypto vs. Traditional Finance

The exotic options market in crypto is significantly influenced by several factors that distinguish it from traditional finance. The primary driver behind the use of exotic options is the relatively unattractive yield offered by vanilla options. In traditional finance, exotics often involve strategies such as selling put options to obtain higher yields, which is justified by the increased risk and complexity associated with these instruments. However, in the crypto space, the inherent volatility already provides substantial yields through vanilla options, reducing the demand for more complex exotic structures.

Impact of Spot ETFs on the Crypto Derivatives Market

The introduction of spot Bitcoin and Ethereum ETFs could potentially transform the crypto derivatives landscape. These ETFs provide a more accessible means for traditional investors to gain exposure to cryptocurrencies and could pave the way for increased demand for options on these ETFs. As traditional financial institutions and wealth managers gain access to crypto products through ETFs, there might be a more significant flow of institutional and high-net-worth investors into the crypto market. This shift could lead to more sophisticated derivative products becoming mainstream.

Deribit’s Dominance and Market Dynamics

Currently, Deribit remains a dominant player in the offshore crypto options market, benefiting from its first-mover advantage and specialized focus. The resilience of Deribit in retaining market share despite competition is noteworthy, and the platform's ability to handle block trading effectively reinforces its position. While Binance and other exchanges focus on high-volume Delta 1 products, Deribit continues to excel in options trading. The different focuses of these exchanges create a situation where the volume for related products often resides on separate platforms.

Conclusion

Neo's journey from traditional finance to the crypto derivatives market offers valuable insights into the challenges and opportunities in volatility trading. The discussion highlights the complexities of managing risk in exotic derivatives, particularly during extreme market events like COVID-19. It also underscores the unique dynamics of the crypto market, where perpetual contracts play a central role, and traditional hedging strategies may need to be re-evaluated. As the crypto derivatives market continues to evolve, the experiences and insights of seasoned traders like Neo will be crucial in navigating this rapidly changing landscape.

AMBERDATA DISCLAIMER: The information provided in this research is for educational purposes only and is not investment or financial advice. Please do your own research before making any investment decisions. None of the information in this report constitutes, or should be relied on as a suggestion, offer, or other solicitation to engage in, or refrain from engaging, in any purchase, sale, or any other investment-related activity. Cryptocurrency investments are volatile and high risk in nature. Don't invest more than what you can afford to lose.